Credit default swaps and financial stability: risks and regulatory issues

Abstract

The credit default swap (CDS) market has grown much faster than other derivatives markets since its inception. Even though it is dwarfed by the interest rate derivatives market, which is eight times larger, its growth has affected the stability of the financial system. CDS were originally designed as a risk transfer tool to allow investors to hedge their position in the debt of a reference entity, but much of the activity in this market is also speculative (Olleon-Assouan, 2004). Risk management in the CDS market has certainly improved significantly, reflected in the fact that gross notional volumes have fallen remarkably as a result of trade compression. Nevertheless there is still no accurate indication of how much risk has actually been transferred with these instruments, and this is a major concern for financial stability. Even a rough estimate of market size ranges from USD 29 trillion to USD 38 trillion at end-2008. Clarifying and harmonising information is vitally important, particularly since the uncertainty surrounding market participants’ risk exposure contains the seeds of systemic contagion. There is now a pressing need for better market supervision based on the active participation of regulators. The task has already been made easier by a number of public and private initiatives aimed at improving the functioning of the market and monitoring risks more effectively. The most tangible evidence of these combined efforts can be found in various plans for a clearinghouse that emerged in 2008 and 2009. Aside from its practical limitations, however, this solution cannot be extended to all CDS classes. And regulators still face the sizeable challenge of assessing overall counterparty risk on the CDS market and preventing concentration and formation of systemic exposures.

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